Five Year Ownership Requirement For Tax-Free Sale of a Personal Residence

The American Jobs Creation Act of 2004 imposed a new five-year ownership requirement for tax-free sale of a personal residence originally received as replacement property in a tax-deferred like-kind exchange. The new requirement is effective for transactions occurring on or after October 22, 2004.

Taxpayers generally may exclude up to $250,000 ($500,000 for married couples filing a joint return) of gain realized on the sale of a personal residence if they have owned the residence and resided in it for periods adding up to two-years of the five-year period ending on the date of sale (IRC §121).

Under the new law, the exclusion of gain on the sale of a personal residence does not apply if the sale occurs within five years of the acquisition date of the property if the property was originally received as replacement property in a tax-deferred exchange under IRC §1031.

In the context of 1031 Exchanges, taxpayers frequently exchange investment property for replacement property that they intend to eventually convert (tax-free) into a personal residence. Usually the conversion occurs a year or so after the residence is acquired as 1031 replacement property and held for the required investment purposes. Then, the taxpayers move into the residence, live there for two-years making the residence eligible for the exclusion for sale of a personal residence.

Using this strategy, it has been possible for taxpayers to cash out of several investment properties sequentially over a period of years, acquiring replacement property more suitable for potential personal residency, converting it to personal residences for the required two-years, selling it tax-free and then moving on to the next tax-deferred exchange and conversion to a personal residence.

The IRS has been aware of this tax-planning "loophole" and has desired to extend the two-year ownership requirement for personal residence exclusion of gain. The American Jobs Creation Act of 2004 does this.

Observation - A taxpayer is not compelled to live in the residence for five-years. The taxpayer is only compelled to own the residence for five-years from the acquisition date and reside in it for periods of time adding up to two-years during the five-year period for the full gain exclusion.